Financial System

Banking System

Mexico has one of Latin America's most developed banking systems,
consisting of a central bank and six types of banking institutions:
public development banks, public credit institutions, private commercial
banks, private investment banks, savings and loan associations, and
mortgage banks. Other components of the financial system include
securities market institutions, development trust funds, insurance
companies, credit unions, factoring companies, mutual funds, and bonded
warehouses.

The central bank, the Bank of Mexico (Banco de México), regulates
the money supply and foreign exchange markets, sets reserve requirements
for Mexican banks, and enforces credit controls. It serves as the fiscal
agent of the federal government, the issuing bank for the new peso, and
a discount house for private deposit banks. It supervises the private
banking sector through the National Banking Commission, and it provides
funds for government development programs. Legislation in 1984 required
the Bank of Mexico to limit its lending to the government to an amount
fixed at the beginning of each year. To ensure continued control of
inflation, the central bank was made autonomous in April 1994.

Mexico has a number of other official banks for agriculture, foreign
trade, cooperatives, public works, housing, transportation, and the
sugar industry, among other specialized purposes. The most important
such development institution is the Nafinsa, which provides financial
support for Mexico's industrialization program. Nafinsa provides
medium-term financing and equity capital for productive enterprises,
promotes Mexican investment companies, oversees the stock market and the
issuance of public securities, and serves as the legal depository of
government securities. By 1993 Nafinsa had divested itself of some of
its interests, but it remained under state ownership. Mexico's other
most important state development bank is the National Bank of Public
Works and Services (Banco Nacional de Obras y Servicios Públicos).

The private banking sector consists of more than 200 banks, which
together have more than 2,500 branches. The proliferation of banking
institutions resulted from regulations that prohibited any single bank
from combining more than two banking functions. Mexico's two largest
private banks are the Bank of Commerce (Banco de Comercio--Bancomer),
comprising thirty-five affiliated banks with more than 500 branches, and
the National Bank of Mexico (Banco Nacional de México--Banamex).
Development banks, known as financieras and organized by
commercial banks in association with major industrial enterprises,
provide most of the private sector's development financing.

In an effort to stem massive capital flight, President López
Portillo decreed the nationalization of the country's private banks in
September 1982. In August 1983, the government authorized the return of
up to 34 percent of the equity shares in these banks to the private
sector, and it eliminated eleven banks and merged fifty others into
twenty-nine national credit institutions in an effort to improve the
banking system's efficiency. In March 1985, the government announced a
further reduction in the number of commercial banks, from twenty-nine to
eighteen.

The government took its first actual step toward reprivatizing the
commercial banks in 1987, when it returned 34 percent of their capital
to private investors in the form of nonvoting stock. In 1990 it allowed
the sale to foreign investors of 34 percent of nonvoting shares in
state-owned commercial banks. Reprivatization began in earnest in June
1991. By July 1992, all eighteen commercial banks had been sold to
private owners, yielding more than US$12 billion. The privatization
program dramatically increased the number of investors holding stock in
Mexican commercial banks from just 8,000 on the eve of the 1982
nationalization to 80,000 in January 1993.

To improve the availability of credit, the government allowed the
establishment of new domestic banks in Mexico in 1993, and the following
year it allowed United States and Canadian banks to begin operating in
Mexico. At the end of 1994, there were some fifty commercial banks in
operation in Mexico, up from nineteen at the end of 1992. Mexico had
forty-five brokerage houses, fifty-nine insurance companies,
seventy-four leasing companies, sixty-five factoring houses, and
forty-nine exchange houses.

Following the currency crisis of late 1994, the government was forced
to raise interest rates sharply in order to protect the new peso by
retaining existing short-term foreign investment and attracting new
capital inflows. High interest rates during 1995 sharply increased the
payments owed by Mexican individual and business borrowers, many of whom
could not shoulder the increased burden. As a result, the share of
nonperforming to performing loans held by Mexican banks rose
significantly, creating a major crisis for the financial sector. During
the first three quarters of 1995, the ratio of bad debts to the banking
system's total loan portfolio increased from 8 percent to 17 percent.
Partially as a result, the rate of growth in commercial bank financing
of private-sector activities declined to just 1 percent during this
period, compared with 19 percent a year earlier.

The interest rate increase also raised the cost to banks and the
government of the various efforts to resolve the problem of banks'
nonperforming loans. In late 1994, the government took over Banca Cremi,
and a year later it was forced to take control of Inverlat. The
government also agreed to assume problem loans held by Banamex and
Bancomer.

In the wake of the financial sector crisis, the government introduced
in mid-1995 a program for rescheduling bank loans using index-linked
investment units. In September 1995, the government unveiled another
emergency program of aid for bank debtors, which was to provide relief
for 8 million bank debtors. By February 1996, 83 percent of eligible
loans had been restructured under this program. By mid-1996, the cost of
the government's various efforts to prevent a banking system collapse
was estimated at 91 billion new pesos. The government held control of 25
percent of bank assets, despite having privatized the banking system
only four years earlier. The government's efforts to restore the
financial sector's stability were rewarded by a sharp drop in interest
rates in late 1995 and early 1996.

Stock Exchange

Shortly after taking office, President de la Madrid allowed the
establishment of private brokerage houses with wide latitude to conduct
financial transactions in domestic capital markets. That action laid the
foundation for the first significant stock market in Mexican history,
the Mexican Stock Exchange (Bolsa Mexicana de Valores--BMV). Following
several years of dynamic growth, the BMV's leading index fell sharply as
a result of the October 1987 United States stock market crash. The BMV
recovered slowly in 1988, then surged ahead from 1989 through 1991. By
the early 1990s, the BMV had become one of the world's fastest growing
stock exchanges. During 1991 the index of traded stocks rose 128 percent
in new peso terms and 118 percent in United States dollar terms.
Analysts attributed the stock market's buoyancy to increased confidence
in the economy and to expectations of lower interest rates and approval
of NAFTA.

In 1992, 199 companies were listed as trading on the stock exchange.
A total of 11 trillion new pesos were traded, and the exchange had a
total capitalization of US$139 billion and a price-to-earnings ratio of
more than thirteen. The total value of stocks traded increased by US$191
billion between 1987 and 1993. Treasury bills, bank acceptances, and
commercial paper were the most common instruments traded. At the end of
1993, Mexican investors held about 75 percent of the equities traded.
Although the value of Mexican-owned stocks rose by about US$143 billion
between 1987 and 1993, only 0.2 percent of all Mexicans had brokerage
accounts at the end of 1992.

The BMV's market value stood at about US$200 billion at the end of
1993. Analysts attributed the rise partly to expectations of higher
profits resulting from a 1 percentage point reduction in the corporate
tax rate, lower energy prices for industrial users, and euphoria over
the passage of NAFTA. Despite a setback induced by the January 1994
Zapatista rebellion in the state of Chiapas, the BMV continued its
strong growth in early 1994. Beginning in March, however, the market was
buffeted by a series of political shocks--including two high-profile
political assassinations, revelations of high-level corruption in
President Salinas's entourage, and continued unrest in Chiapas--that
contributed to its high volatility throughout the rest of the year.

The stock market was further buffeted by the collapse of the new peso
in early 1995, causing the stock index to fall to less than 1,500 points
in February of that year. The main stock index gradually recovered to
just under 3,000 points by the end of 1995 and had reached 3,300 by
September 1996. Mexican stocks gained 24 percent in dollar terms during
the first eight months of 1996. Mexico's stock market had a US$70
billion capitalization in September 1996, according to Morgan Stanley
Capital International indices.

Exchange Rate

From December 1982 until November 1991, the Mexican peso had two
rates of exchange against the United States dollar--the controlled or
"official rate" and the "free rate." The controlled
rate applied to income from most merchandise exports, to funds used by maquiladora
(see Glossary) assembly industries for local expenditure other than
fixed assets, to nearly all import payments, and to principal and
interest payments and other credit expenses. The free rate applied to
most other transactions, such as tourism and profit remittances.

In November 1991, the government eliminated all exchange controls,
thereby unifying the various peso exchange rates. The regime freed the
peso to float within a band, the bottom of which was fixed at 3,051
pesos per dollar and the top of which was devalued by 0.2 pesos per day.
Renewed pressure on the peso forced the authorities in October 1992 to
raise the average daily depreciation to 0.4 pesos per dollar, increasing
the peso's annual rate of devaluation to less than 5 percent. The peso
continued to appreciate in real terms, however, because Mexico's
inflation rate exceeded that of the United States by some 8 percentage
points. The government was reluctant to devalue the peso to the full
extent of the inflation differential with the United States because it
feared that a large devaluation would exacerbate domestic inflation and
undermine public confidence in the stability of the government's
macroeconomic policy. It preferred to compensate for the less
competitive position of the peso by increasing productivity within
Mexico. In January 1993, the government introduced the new peso, worth
1,000 of the old and divided into 100 centavos, to simplify foreign
exchange.

Intense international demand for Mexican stocks and high-yielding
two-year treasury certificates, known as cetes , kept the new
peso at a stable level of 3.1 new pesos per dollar for most of 1993.
Uncertainty about NAFTA's passage drove the new peso down to 3.3 per
dollar in November 1993, although it soon rallied to 3.1 per dollar as
interest rates rose and NAFTA's prospects of ratification appeared to
improve. By late 1993, the capital influx had overvalued the new peso
against the dollar by some 30 percent, leading some investors to avoid
Mexican currency for fear that the new peso's overvaluation would compel
the government to impose a large devaluation that would sharply reduce
the dollar return of cetes . Some leading private-sector
figures favored devaluation, expecting it to help reduce the trade
deficit, Mexico's need for foreign capital, and thus interest rates.

Political considerations deterred the government from imposing a
devaluation that would lower living standards, jeopardize investor
confidence, and promote capital flight in the months prior to the August
1994 presidential and congressional elections. The slowdown of capital
inflows exerted steady downward pressure on the new peso throughout the
year. By late 1994, the government was drawing heavily on international
reserves to prop up the new peso.

The almost complete disappearance of Mexico's reserves forced the new
Zedillo government to bolster the currency's value. On December 20,
1994, the government raised the ceiling on the exchange rate band from
3.4 to 4.1 new pesos per dollar. However, continued pressure on the new
peso, combined with mounting investor concern about the government's
intentions, forced the administration two days later to let the currency
float. The new peso ended 1994 at 5.3 per dollar. It continued to weaken
during early 1995, as investors doubted the government's ability to
repay the US$29 billion in short-term tesebono debt that would
fall due during that year. In 1995 the exchange rate fell to 6.5 new
pesos per dollar, and in January 1996 it stood at 7.4 new pesos per
dollar.

The average monthly interest rate on twenty-eight-day cetes rose
from 14 percent in 1995 to 49 percent in 1996. When the new peso came
under heavy speculative pressure in late 1995, Mexico's monetary
authorities reacted by raising interest rates sharply. Mindful of the
need to restore investor confidence in Mexico's early economic recovery,
the authorities allowed interest rates to fall at the end of 1995.